Modern Portfolio Theory, the Prevalent Misnomer

In the current investing landscape individuals do not have many choices when it comes to saving for life goals and more importantly how their funds are invested. The big players in the industry may slice and dice the pie chart a little bit differently, but by and large they all follow the same rules and play a similar game. These mainstream investing practices can often be traced to Modern Portfolio Theory or MPT, which is a misnomer as it’s not very modern at all. The theory started to gather momentum in the late 1950’s as basic tenets of money diversification and statistical analysis started to take hold. Investors at that time discovered a way to reduce risk by diversifying their portfolios into multiple investments instead of making one big bet into a single stock. While it is true that diversification can reduce risk, it’s not as simple as just picking multiple investments and calling it good.

The key is to select investments that are NOT correlated to one another and also carry a similar expected rate of return. If you pick multiple investments that are highly correlated to one another, meaning the price moves up and down at the same time, you essentially have made one bet without reducing much risk. If however you can find investments with low price correlation and a similar rate of return, then you can split your money between them and reduce your risk without hurting your return potential. This is what we call effective diversification at Altruistic Investing and what traditional MPT often times fails to produce.

So why does any of this matter to you? Managed investment accounts take MPT ideas and build models that are supposed to fit individual investors. You have probably seen at some time in your life the classic 60% stock 30% bond and 10% cash pie chart with stocks being allocated to different categories-large, small, mid and international and bonds being a combination of corporate, municipal and U.S. government. Financial Planners take a model like this and apply it to an investor based on their age, tolerance for risk and current situation. The idea is to then change the level of risk based on how the individual’s life changes over time, typically getting more conservative as a goal approaches or the investor gets older. However, there is little to no monitoring of correlation between the underlying assets and unfortunately the pie chart is often times not updated until a crisis situation occurs in the markets and it’s already too late. That in a nutshell is old investment management that is still mainstream and in our estimation leaves individuals more susceptible to market risk than need be so.

What we do differently is calculate correlation and volatility on a daily basis. This allows us to be proactive instead of reacting to market swings after it is too late. We make adjustments to our “pie chart” based on real world moving parts and closely monitor five investing characteristics we call factors – Size, Volatility, Momentum, Quality and Value. This means you can confidently stay invested in all market situations knowing that we have your back. We will make adjustments as market conditions change, instead of simply investing into asset classes that may or may not be correlated to one another. MPT moved us forward and has helped people invest more effectively, but it’s time to accept its limitations and invest with truly modern technology. Altruistic Investing is the next generation of investing, truly modern in practice and theory.

Stephen Heitzmann is the CEO of Altruistic Investing LLC, an Algorithmic Virtual Advisor, based in Colorado Springs, CO. Altruistic Investing LLC is a Registered Investment Advisor (Firm CRD# 289016 / SEC#801-110892) with the Securities and Exchange Commission.

This article does not represent an investment recommendation or endorsement of any kind. Please consult with your advisor regarding your specific situation. Investing in securities does involve risk of loss that clients should be prepared to bear. The risks can range from failing to keep pace with inflation to losing some or all of the money you invest.